German, French and Dutch yields have been sliding for months as the eurozone
recovery wilts and several countries flirt with recession

Bond yields have fallen to the lowest level in modern history in Germany, France and the eurozone’s core states, signalling a high risk of deflation and mounting concerns about sanctions against Russia.

The yield on German 10-year bonds fell to a record low of 1.11pc in intra-day trading, partly on safe-haven flows. French yields dropped in tandem to 1.5pc. These levels are far below rates hit during the 1930s or even during the deflationary episodes of the 19th Century.

“Yields fell this low in Genoa in the 15th century but there has been nothing like this in Europe in modern times,” said professor Richard Werner, from Southampton University. “This reflects the weakness in nominal GDP and a slow economic implosion caused by credit contraction. The European Central Bank is at last starting to act but it is only scratching the surface.”

German, French and Dutch yields have been sliding for months as the eurozone recovery wilts and several countries flirt with recession, but the latest plunge reflects a confluence of forces. “Investors may fear that the worsening tensions with Russia could be the external shock that finally pushes the eurozone into a deflation trap,” said Simon Tilford, from the Centre for European Reform.

Bond yields have also fallen to all-time lows in Spain and Italy but the “risk-spread” over German Bunds has been widening over recent weeks. The cost of insuring Italy’s debt through credit default swaps has risen by a third since June.

European diplomats reached a deal on Tuesday on “tier 3” sanctions aimed at shutting Russian banks out of global capital markets and slowly suffocating the Russian economy, though the original plan to limit technology for oil and gas exploration has been diluted. Creditors have already frozen a $1.5bn loan for VTB bank due to be agreed last week.

The European Commission said the measures are likely to cut 0.3pc of GDP off EU economic growth this year, and 0.4pc next year, even if the crisis is contained without a serious disruption of energy supplies. “This is a significant hit to growth. It implies such low growth in parts of southern Europe that it makes it almost impossible to arrest the rise in debt ratios,” said Mr Tilford.

The Moscow newspaper Izvestia said Russia’s parliament is already drawing up legislation to blacklist “aggressor countries”, specifically targeting auditors and consultants. These include Deloitte, KPMG, EY (formerly known as Ernst & Young), Boston Consulting and McKinsey.

Tim Ash, from Standard Bank, said this would trigger clauses on bond covenants that rely on external audits. “If they go down this path they could provoke a brutal market reaction,” he said.

David Owen, from Jefferies, said a lack of genuine economic recovery is what lies behind Europe’s falling yields, already replicating the pattern seen in Japan in the 1990s. “A third of all countries in the eurozone are already in deflation once you strip away taxes, and another four have no inflation, including France and Spain,” he said.

“Corporate profits fell in the first quarter, and so did household disposable income, if you exclude Germany. We are seeing no growth at all in world trade, which is highly unusual. The CPB trade index rolled over in May and fell 0.6pc,” he said.

Mr Owen said investors are starting to price in quantitative easing by the ECB, which would entail sovereign bond purchases and potentially push yields lower. The Bundesbank would be the biggest buyer on a pro-rata basis under the ECB’s “key”, but German debt is relatively scarce. “Investors know this and it is driving Bund yields even lower,” he said.

For Russia, deep recession looks inevitable. The commission said sanctions will cut Russia’s growth by 1.5pc in 2014, and by 4.8pc in 2015. A return to the Soviet stagnation of the early 1980s is becoming all too likely.